5. Derivatives

Risk Management Objective of Using Derivatives

The Company enters into derivative financial instruments to manage risks related to differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments, currently related to our variable rate borrowing. The Banks have also entered into interest rate derivative agreements as a service to certain qualifying customers. The Banks manage a matched book with respect to these customer derivatives in order to minimize the net risk exposure resulting from such agreements. The Banks also enter into risk participation agreements under which they may either sell or buy credit risk associated with a customer’s performance under certain interest rate derivative contracts related to loans in which participation interests have been sold to or purchased from other banks.

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the notional amounts and fair values (in thousands) of the Company’s derivative financial instruments as well as their classification on the consolidated balance sheets as of March 31, 2013 and December 31, 2012.


						Fair Values (1)
		Notional Amounts				Assets				Liabilities
(in thousands)	Type of Hedge	March 31, 2013		December 31, 2012		March 31, 2013		December 31, 2012		March 31, 2013		December 31, 2012
Derivatives designated as hedging instruments:
Interest rate swaps	Cash Flow	$	140,000	$	140,000	$	—	$	—	$	126	$	298

		$	140,000	$	140,000	$	—	$	—	$	126	$	298

Derivatives not designated as hedging instruments:
Interest rate swaps	N/A	$	593,703	$	547,477	$	20,390	$	19,448	$	21,093	$	20,157
Forward commitments to sell residential mortgage loans	N/A		106,105		115,256		346		190		633		590
Interest rate-lock commitments on residential mortgage loans	N/A		70,898		58,135		505		455		218		55
Risk participation agreements	N/A		21,165		—		13		—		5		—

		$	791,871	$	720,868	$	21,254	$	20,093	$	21,949	$	20,802

(1)	Except for $96 at March 31, 2013 and $218 at December 31, 2012 in loans held for sale, assets are recorded in other assets. Liabilities are recorded in other liabilities.

Cash Flow Hedges of Interest Rate Risk

At both March 31, 2013 and December 31, 2012, the Company was party to an interest rate swap agreement with a notional amount of $140 million that was designated as a cash flow hedge of the Company’s forecasted variable cash flows under a variable-rate term borrowing agreement. The swap agreement expires in June 2013. Under the swap agreement, the Company receives interest on the notional amount at a variable rate and pays interest at a fixed rate.

The effective portion of changes in the fair value of derivatives designated and qualifying as cash flow hedges is recorded in accumulated other comprehensive income (“AOCI”) and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The impact on AOCI was insignificant during 2012, and the impact of reclassifications on earnings during 2013 has been and is expected to continue to be insignificant. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. No hedge ineffectiveness was recognized during the three months ended March 31, 2013. Amounts reported in AOCI related to these derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate liabilities. During the next twelve months, the Company estimates that $0.1 million will be reclassified as a decrease to interest expense.

Derivatives Not Designated as Hedges

Customer interest rate derivatives

The Banks enter into interest rate derivative agreements, primarily rate swaps, with commercial banking customers to facilitate their risk management strategies. The Banks simultaneously enter into offsetting agreements with unrelated financial institutions, thereby mitigating its net risk exposure resulting from such transactions. Because the interest rate derivatives associated with this program do not meet hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

Risk participation agreements

The Banks also enter into risk participation agreements under which they may either assume or sell credit risk associated with a borrower’s performance under certain interest rate derivative contracts. In those instances where the Banks have assumed credit risk, they are not a direct counterparty to the derivative contract with the borrower and have entered into the risk participation agreement because they are also a party to the related loan agreement with the borrower. In those instances in which the Banks have sold credit risk, they are the sole counterparty to the derivative contract with the borrower and have entered into the risk participation agreement because they sold a portion of the related loan. The Banks manage their credit risk under risk participation agreements by monitoring the creditworthiness of the borrower, based on their normal credit review process.

Mortgage banking derivatives

The Banks also enter into certain derivative agreements as part of their mortgage banking activities. These agreements include interest rate lock commitments on prospective residential mortgage loans and forward commitments to sell these loans to investors on a best efforts delivery basis.

Effect of Derivative Instruments on the Income Statement

The effect of the Company’s derivative financial instruments on the income statement was immaterial for the three months ended March 31, 2013 and 2012.

Credit-risk-related Contingent Features

Certain of the Banks’ derivative instruments contain provisions allowing the financial institution counterparty to terminate the contracts in certain circumstances, such as the downgrade of the Banks’ credit ratings below specified levels, a default by the Bank on its indebtedness, or the failure of a Bank to maintain specified minimum regulatory capital ratios or its regulatory status as a well-capitalized institution. These derivative agreements also contain provisions regarding the posting of collateral by each party. As of March 31, 2013, the aggregate fair value of derivative instruments with credit-risk-related contingent features that were in a net liability position was $18.6 million, for which the Banks had posted collateral of $15.0 million.

Offsetting Assets and Liabilities

Offsetting information in regards to derivative assets and liabilities subject to master netting agreements at March 31, 2013 and December 31, 2012 is presented in the following tables:


As of March 31, 2013 (in thousands)							Gross Amounts Not Offset in the Statement of Financial Position
Description	Gross Amounts Recognized		Gross Amounts Offset in the Statement of Financial Position		Net Amounts Presented in the Statement of Financial Position		Financial Instruments		Cash Collateral		Net Amount
Derivative Assets	$	20,390	$	—	$	20,390	$	—	$	—	$	20,390

Total	$	20,390	$	—	$	20,390	$	—	$	—	$	20,390

Derivative Liabilities	$	21,219	$	—	$	21,219	$	—	$	15,032	$	6,187

Total	$	21,219	$	—	$	21,219	$	—	$	15,032	$	6,187


As of December 31, 2012							Gross Amounts Not Offset in the Statement of Financial Position
Description	Gross Amounts Recognized		Gross Amounts Offset in the Statement of Financial Position		Net Amounts Presented in the Statement of Financial Position		Financial Instruments		Cash Collateral		Net Amount
Derivative Assets	$	19,448	$	—	$	19,448	$	—	$	—	$	19,448

Total	$	19,448	$	—	$	19,448	$	—	$	—	$	19,448

Derivative Liabilities	$	20,455	$	—	$	20,455	$	—	$	16,839	$	3,616

Total	$	20,455	$	—	$	20,455	$	—	$	16,839	$	3,616